Why Index Funds Beat Actively Managed Funds

Investor looking at multiple screens of actively managed funds
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Actively managed investments are those in which a manager or broker buys and sells single investments in an effort to beat the performance of a market index. While they may perform well in the short term, most don't do as well in the market after one year. Index funds, meanwhile, tend to have higher returns over longer periods of time. This is because an index fund, which is a type of mutual fund or exchange-traded fund (ETF), tracks a specific set of investments and strives to gain the same returns as them, which makes an index fund passively managed.

With index funds, there is no need for the intense research and analysis needed to find stocks that may do better than others during a given time frame. This passive nature allows for less risk and lower fees and expenses.

Index funds such as the best S&P 500 index funds are intended to match the holdings and performance of a stock market benchmark such as the S&P 500.

Fund Manager Risk

Fund managers are human, which means they are prone to human emotion and human error. Their job is to beat the market, which means they must often take on conscious market risk in order to obtain good returns.

This risk is all but removed with index funds. There is no real risk of human error with an index fund manager, at least in terms of stock selection. The investments in the fund are not chosen by one person but rather based on a selection of well-performing investments. Even an active fund manager who is able to avoid human emotion and error can't get past the unpredictable nature of the stock market.

In other words, an experienced fund manager with skill, knowledge, and nerves of steel is no match for market ups and downs.

Management Expenses

It takes time and skill to create a mutual fund. Firms that offer mutual funds to the public need to pay the managers of these funds for their time and skill. Since index funds are passively managed, the cost of managing them is expressed as an expense ratio, which means that the cost of managing these funds is pretty low, compared to funds that are created for, and focused on, beating market averages.

Because index fund managers aren't trying to beat the market, they can save money by keeping management costs low and keeping those savings invested in the fund.

In 2020, index fund expense ratios averaged 0.06%, whereas the average actively managed mutual fund had expenses of around 0.71% or higher. This means that on average, an index fund investor can begin each year with a 0.67% head start on actively managed funds. This may not seem like a big deal, but a 0.67% (or more) lead on an annual basis makes it harder for active fund managers to beat index funds over long periods of time.

Even the best fund managers in the world can't always beat the S&P 500 for more than five years. A 10-year winning streak is almost unheard of in the investing world.

Trendiness

Index funds, especially the best S&P 500 index funds, maintain large numbers of investors and high levels of investor assets. They don't have sudden peaks or troughs in acclaim or trendiness. This is a strength of index funds.

By contrast, many actively managed mutual funds become trendy because a fund manager has beaten the market for more than a few years. As more and more investors become aware of the positive trend, the mutual fund attracts more assets in the form of investor money.

This growth can cause trouble in two ways. First, the fund manager may be forced to buy more shares of larger companies or stocks. This action is called "style drift." Second, the hot streak will end at some point, and investors might then leave the fund. If too many people leave the fund at the same time, the fund could end up with a lack of funding. The manager must sell stock holdings to create cash for people who leave the fund, which then slows how well the fund does for people who still have money in it.

Saving Time

One of the central ideas of investing in all groups of mutual funds is to make investing easier and more accessible to the average or new investor, but choosing the best mutual funds can take up a lot of time.

Investing in index funds means that you won't expend too much time and energy on researching funds and managing your portfolio. You put your money on autopilot, which takes away worry and frees up your time for more important efforts. Isn't that why you make money in the first place?

The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.

Key Takeaways

  • Passive investing is easier and comes with less stress. This method shortens the time and effort investors spend choosing where to put their money.
  • Managers come with extra fees, and they come with the risk of human error.
  • Investors look at index funds as more stable. Active funds are more likely see to changes according to trends.